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WEAKENING ADVERTISING TRENDS and a heavy debt load have turned former investor favorite
R.H. Donnelley,
the second largest independent yellow-pages publisher, into one of the biggest losers this year on the New York Stock Exchange. R.H. Donnelley shares (ticker: RHD) have fallen 94%, to $2.00, so far in 2008, and are off 97% from their August 2007 high of of 68. Though still profitable, the company has a market value of under $150 million, down from $4.8 billion a year ago.

Investors long considered yellow-pages publishers stable, high-margin cash cows capable of carrying high debt loads. That perception has changed dramatically in the past year amid advertising declines and fears about whether Americans are forsaking print yellow-pages books for online searches. Reflecting investor concerns, some of R.H. Donnelley's debt trades for just 50 cents on the dollar, which works out to a yield of over 25%. That may make the bonds a safer play than the shares, which also hold promise.

R.H. Donnelley is far from dead. The company expects to generate $475 million to $525 million in free cash flow this year. It has no major debt maturities until 2010. Thus, investors probably get a two-year "look" at Donnelley's business before possible problems loom in 2010, when it will have $1.4 billion in maturing debt. Admirers admittedly are few, with only one of the six Street analysts who cover the company rating it a Buy. About 24 million shares have been sold short out of nearly 70 million outstanding.

IT IS RARE TO FIND A COMPANY with a market value of less than $150 million that is generating $500 million in annual free cash flow. The problem for equity investors is that none of that cash flow is heading directly to them. Instead, management is earmarking all its free cash for debt repayment.

This conservative approach could be a mistake. A $2 stock price sends a message to the world that a company is in dire straits. One fan of the stock says the company should make a tender offer for 25% of its shares at $3 to $4 apiece. If fully subscribed, that would cost no more than $75 million, a fraction of R.H. Donnelley's projected 2008 free cash flow. It would demonstrate that management has some concern for shareholders, and could boost the stock.

R.H. Donnelley also could take advantage of the depressed prices of its bonds to repurchase debt and reduce its financial leverage, a step management is considering. An activist investor also may get involved.

A similar prescription -- stock buyback plus bond repurchase -- could work for Idearc, as well. The company has a market capitalization of $200 million and nearly $9 billion of debt. Idearc trades for just 0.5 times projected 2008 profits of $2.55 a share, and no, that's not a misprint. The company earned 52 cents a share in the second quarter. Like R.H. Donnelley, it pays no dividends, though its cash flow hasn't held up as well.

R.H. DONNELLEY AND IDEARC need to reverse recent advertising declines and maintain cash flow if their stocks are to have value long term. Both are fighting the perception that print yellow pages are doomed, not an easy endeavor given an 8.6% drop in Donnelley's advertising sales in the second quarter.

"Wall Street has it completely wrong, and that's completely understandable," says David Swanson, R.H. Donnelley's chief executive. "They think we sell a product that's falling off a cliff. That assumption is wrong."

Stock analysts are "the worst demographic for yellow-pages usage," Swanson adds. "Just because they don't use it, they assume nobody is. If you go to Cedar Rapids, Iowa, the print yellow pages is a much more stable" business than it may be in Manhattan.

Swanson argues the yellow pages are much healthier than newspapers, another tough media business. R.H. Donnelley has a wide base of 600,000 advertisers, mostly small and medium-sized businesses that have few other low-cost alternatives to connect with consumers. About 80% of revenue come from service-based businesses, including plumbers, landscapers and locksmiths.

The average advertiser spends about $3,500 a year. Newspapers, in contrast, have heavily relied on ailing ad categories like retailing, autos, real estate and classifieds.

The Bottom Line:

R.H. Donnelly's stock has plummeted to $2 from $68 on fears its debt will drag it into bankruptcy. If its business stabilizes, however, the stock could rally. The bonds also look good.

A key issue for R.H. Donnelley is whether recent ad declines represent a permanent shift away from yellow pages, or simply reflect a weak economy. Swanson argues the latter, saying this economy is one of the "worst" he's seen in 30 years for small and medium-sized concerns. Ads from housing-related businesses such as mortgage lenders, real-estate services and contractors are hurting. Some bright spots include pawnbrokers, bankruptcy lawyers, cleaning services, junk dealers and dumpster rentals.

Donnelley's strategy is to offset declines in high-margin print yellow pages with online yellow pages and business-to-business e-commerce, which it calls its "triple play."

The overall strategy is having some success, though the company doesn't break out the electronic contributions. Second-quarter revenue of $663 million was little changed from the year-earlier period, as was pre-tax cash flow of $366 million. The company reaffirmed its pre-tax cash-flow projection of $1.35 billion to $1.4 billion but reduced by $20 million its projected 2008 free-cash flow (cash flow after deducting for interest expense) to a range of $475 million to $525 million.

Donnelley reported a $339 million loss for the second quarter, reflecting a write-down of non-cash goodwill. It earned $89 million from operations. One attribute is about $2 billion of tax benefits, which can be used to offset income taxes, assuming it stays profitable.

R.H. Donnelley is in a bind, with debt equal to a stiff seven times annual cash flow. Most companies try to keep this ratio below three. Its stock represents a bet that yellow pages will stay popular in the Cedar Rapids' of America, attracting more advertisers as well as users of the familiar fat books.

If that's the case, the stock could shoot up. And if it's not, it probably will take another two years, at least, before its debt load sinks the company. That probability alone could be worth more than $2 a share.